All investors are about to get deep cuts in the taxes they pay on capital gains, no matter what their income-tax bracket is.
In the first major tax reductions since 1981, the White House and Republican leaders in both chambers have agreed to give investors a break on profits from the sale of stocks, bonds, property and most other assets.
“Capital gains used to be something only rich men enjoyed, but today almost everybody has some through mutual funds or stocks they own, and they will all benefit,” says John Wilkins, a director of tax policy economics at Coopers & Lybrand in Washington.
Under the tax-cut agreement, most investors will pay capital-gains taxes at a new 20 percent rate on assets held for at least 18 months. That’s down from a top rate of 28 percent under current law. Profits on assets purchased after 2000 that are held at least five years will be taxed at a top rate of 18 percent.
Investors in the lowest income-tax bracket (singles with taxable income of $24,650 or less, and couples with $41,200 or less) will pay a 10 percent capital-gains tax, down from 15 percent. These investors will also get a super-low 8 percent tax rate for gains on investments held five years or more.
Here’s how to reap the most tax savings from lower capital-gains rates:
– Invest in stocks. Shovel more of your savings into investments that tend to appreciate in price, especially stocks and stock funds that pay small dividends or none at all. Dividends are taxed as ordinary income, at rates that now are always more costly than capital gains.
But don’t let taxes rule your investment decisions. Low-yielding growth stocks tend to zigzag in price more than stodgier, high-yielding blue chips. Make sure the small extra tax savings you’ll get is worth the added risk of owning such shares, advises Peter L. Bernstein, a Wall Street researcher who studies risk.
– Beat the dividend. Although dividend income doesn’t qualify for the lower tax rates levied on capital gains, it is possible to capture the dividend as a capital gain provided you’ve held it long enough.
The trick is to sell your shares while their price is fat with an expected dividend payment. This lets you “avoid the dividend income, but receive its value in the form of a capital gain,” says Robert Willens, a tax and accounting analyst at Lehman Brothers in New York.
With stocks, the day to sell is one day before the ex-dividend date, which is the day shares start trading at prices that no longer reflect a stockholder’s rights to a declared dividend. Stocks traded on the New York Stock Exchange go ex-dividend two business days before the record date, or the day when shareholders must officially own shares to be entitled to the dividend.
Mutual funds have a different schedule: Investors must sell fund shares a day before the record date, which for funds is the day before a fund goes ex-dividend.
A broker or the investor-relations folks at the companies or funds in which you hold shares will be able to help you figure out the right day. Be sure your savings from this maneuver exceed any trading costs.
– Avoid frequent trading. To generate tax-favored capital gains, you must now hang on to stocks, funds and other assets for at least 18 months before ditching them. So-called short-term gains on assets held for less than 18 months will be taxed at the higher, ordinary-income rates.
Fund investors should go one step further. They should favor funds run by managers who tend to make long-term bets, rather than those who tend to buy and sell stocks in search of a quick profit. That’s because all the short-term gains in a fund will be distributed to you as taxable ordinary income. You can get a rough measure of a fund manager’s tendency to trade by asking your broker or a fund shareholder representative for the fund’s “turnover ratio,” says New York accountant and financial planner Joel Isaacson. Unmanaged index funds almost always have extremely low turnover, he says.
– Transfer stock. Giving highly appreciated stock to relatives makes more sense now that the tax hit to the recipient is less, points out Martin Nissenbaum, national director of personal-income-tax planning for Ernst & Young. On the other hand, giving the highly appreciated shares to a charity seems less appealing.
– Keep some stocks in taxable accounts. Assets in tax-deferred accounts such as individual retirement accounts and 401(k) retirement-savings plans won’t benefit from the capital-gains tax cuts. That’s because you must pay taxes on every dollar of earnings taken out of a tax-deferred account at the higher, ordinary-income rate.
As a result, some people should consider keeping stocks outside these plans so they can preserve the tax-favored capital-gains treatment, says Richard Stevens, a principal at Vanguard Group, Malvern, Pa. They include investors planning to make withdrawals in fewer than 10 years or those who believe they’ll be in the highest (39.6 percent) tax bracket when they yank money out, he says.
– Squeeze tax savings from workplace benefits. In your employee-compensation package, request incentive stock options, or ISOs, in place of any non-qualified stock options. As long as you hold the shares acquired through the exercise of the ISOs for at least one year (and two years after the option was granted), the spread between the option price and the sale price is taxed as a long-term capital gain. With non-qualified options, this spread is taxed at the higher, ordinary-income rate.
